Interest rates affect economic activities at all levels. Central banks, including the Federal Reserve (informally known as the Fed) target interest rates as a policy tool to influence economic activity. Interest rate derivatives are popular with investors who require customized cash flow needs or specific views on interest rate movements.

One of the key challenges that interest rate derivative traders face is to have a good and robust pricing procedure for these products. This involves understanding the complicated behavior of an individual interest rate movement. Several interest rate models have been proposed for financial studies. Some common models studied in finance are the Vasicek model, CIR model, and Hull-White model. These interest rate models involve modeling the short rate and rely on factors (or sources of uncertainty) with most of them using only one factor. Two-factor and multifactor interest rate models have been proposed.

In this chapter...